Robert Kiggins discusses US corporate inversions and why there is a push by some politicians for a tightening up on the rules surrounding them.

What is an Inversion?

At its most cynical, a US inversion is the term used to describe the process whereby a US company moves its “headquarters” — e.g. a mere post office box address — to an offshore tax haven such as Bermuda or the Cayman Islands while leaving its owners, operations and employees in the United States. This type of sham inversion will not be given effect under US tax law but the example serves to illustrate the fact that in that minds of many, inversions are simply tax dodges.

Less polemically, an inversion is simply a transaction whereby a foreign company acquires all or substantially all of the equity or assets of a US company. In current practice, the US equity owners almost invariably maintain control of the foreign company parent of the post inversion group.

The principal tax motivation for company inversions is that the United States top tier tax rates at 35% of corporate taxable income are among the highest in the world and these apply to worldwide income of a US company. If a US multi-national company can instead pay tax at lower tax rates in a foreign country the savings can be very significant. For example, in a 2013 inversion in the pharmaceutical industry of a US company (Perrigo) into an Irish one (Elan) the effective tax rate was reported as being reduced from 28% to 20% and as resulting in some $50 million in annual tax savings.[1]

Other tax benefits include the freedom to use future non-US earnings to pay dividends, repurchase shares, and purchase US businesses.

Inversions may, aside from tax benefits, have strong business motivations as such as moving into global markets, growing the business using foreign resources, better global cash management, and even enhancing additional acquisitions. Of course, some of the business motivations are related to the tax benefits.

Current Tax Status of US Inversion Transactions

Under the existing US tax laws, discussed in detail in the Appendix, tax-efficient inversions are, in the absence of meeting very stringent requirements for conducting substantial post inversion business activities in the jurisdiction of the foreign company, generally possible only if the former equity owners of the US company own no more than 80 percent of the combined company after the merger or acquisition.

In March 2014, however, the Treasury Department proposed to amend the anti-inversion rules, effective January 1, 2015, to in effect permit tax efficient inversions only if the former equity owners of the US company own no more than 50 percent of the combined company after the merger or acquisition – a change that would significantly reduce the possibility for tax-efficient inversion. An additional provision would render the inversion tax inefficient if the post-inversion group has (i) “substantial business activities” in the United States, and (ii) the foreign company acquired in the inversion is primarily managed and controlled in the United States.

While the prospects for the passage of this Treasury legislation were deemed by many as not likely in 2014, the completion of an inversion transaction by December 31, 2014 would have avoided these proposed rules. Hence tax practitioners were recommending that US companies interested in inverting find a foreign merger partner and complete the deal before the inversion rules are tightened.

Then, in May 2014 Senator Carl Levin and thirteen other Democratic Senators introduced a bill not-so-subtly named “The Stop Corporate Inversions Act of 2014” that would significantly limit, for a two-year “moratorium” period, the ability of US companies to engage in inversion transactions. One of the prominent features is, like the Treasury proposal, a requirement that former equity holders of the US company own no more than 50 percent of the combined company after the merger or acquisition. A significant US business activities test was also added that would effectively squash the tax benefit of inversions if after the inversion there is (i) significant US management and control and (ii) 25% or more of the post inversion group’s employees, assets or income is located or derived in the US.

Moreover, the Levin bill if passed will be retroactive for acquisitive inversions completed after May 8, 2014 but then would expire on May 9, 2016. Hence, there is now nowhere to run on deals that will not meet these more stringent rules if this bill is passed. Again, in the present US Congress, passage of any major tax legislation is at best uncertain but certainly the possibility of passage of the Levin bill could have a chilling effect on inversions.

The Future for Inversions in the US

The smart money is saying that nothing will happen for now in the US with inversion reform bills. The Republicans in the US Congress are reportedly completely uninterested in dealing with inversions except as a part of broad based international tax reform. The Treasury proposal and the Levin bill are each stand-alones and broad based international tax reform in the US is thought to be years away and perhaps not even ever possible here.

Nonetheless, the whole US inversion issue is like our San Andreas fault line[2] in California. In my opinion, tectonic-like economic forces are at work and sooner or later, as more and more US businesses eventually invert abroad, something will crack. Hopefully, it will be our high tax rates and our system of taxing US companies on worldwide, as opposed to territorial, income. However, one certainly couldn’t be shocked to see more stand-alone anti-inversion proposals coming out of the US Congress and one of them could certainly gain enough support to be enacted into law – but, barring the announcement of some new earth shaking inversion mega-deal that goads the US Congress into action, probably just not this year.

APPENDIX [3]
SUMMARY OF CURRENT US ANTI-INVERSION PROVISIONS

Section 367(a)

Final regulations under section 367(a) were issued in 1996. These rules permit the US shareholders of the US target corporation to receive up to 50% of the foreign acquiring corporation’s equity (measured by voting power and value) in the exchange, provided certain other requirements are also satisfied. If this ownership limitation is satisfied, then except as provided in section 367(a)(5), the US transferors are not subject to taxation under section 367(a)(1) if the domestic corporation complies with certain reporting requirements and the following additional conditions are satisfied:

• 50% or less of the total voting power and value of the stock of the foreign acquiring corporation is owned after the transfer by US persons that are either officers, directors or 5% shareholders of the US target corporation.
• Either (a) the US transferor is not a 5% shareholder of the foreign corporation or (b) the US transferor enters into a five-year gain recognition agreement regarding the US target corporation stock it exchanged.
• The active trade or business test is satisfied by the transferee foreign corporation.

Because taxable US persons may comprise a minority of the shareholders of a publicly traded US multinational company, or such shareholders may otherwise have little gain in their shares of the multinational, these rules were generally deemed to be not an effective deterrent to inversion transactions.

Section 7874

In 2004 the US Congress enacted section 7874 to further limit inversion transactions. Section 7874 applies to certain transactions involving corporations and partnerships, including transactions whereby:

1. a foreign corporation acquires (directly or indirectly) substantially all of the properties held by a US corporation,
2. the former shareholders of the US target own at least 80% (or 60%) of the stock of the foreign acquiring corporation by reason of holding stock in the US target, and
3. the expanded affiliated group (EAG) that includes the foreign acquiring corporation does not have “substantial business activities” in the foreign acquiring corporation’s country of incorporation when compared with the total business activities of the expanded affiliated group. 

These tests are applied taking into account all transactions completed pursuant to a series of related transactions.

Section 7874 deals with two levels of inversion transaction:

First, section 7874(a)(2)(B) provides that a foreign acquiring corporation is a “surrogate foreign corporation” to the extent the shareholders of the US target receive at least 60% of the stock of foreign corporation (measured either by voting power or value) in the transaction by reason of owning US target corporation stock, and the foreign corporation’s EAG does not have substantial business activities in its country of incorporation. If a foreign corporation is a “surrogate foreign corporation,” then section 7874(a)(1) provides, at a minimum, that certain gain “inversion gain” recognized by the US target in the inversion transaction (as well as outbound transfers of licenses of property to related parties in the subsequent ten-year period) is taxable in full at the maximum corporate tax rate, without offset by losses, credits or any other tax attributes.

Second, if the foreign corporation is a surrogate foreign corporation and the shareholders of the US target receive at least 80% (measured either by voting power or value) of the stock of the foreign corporation in the transaction by reason of owning US target corporation stock, then section 7874(a)(1) does not apply, but instead section 7874(b) provides that the foreign acquiring corporation will be treated as a US corporation for all US tax purposes.

“Substantially all” test

Slim guidance is provided to determine whether “substantially all” of the assets of a US target corporation have been acquired for purposes of section 7874.. The regulations do provide some clarity, mainly in terms of measuring which assets should be treated as having been acquired by the foreign corporation, as opposed to what level of assets constitutes substantially all. For example, an acquisition of the stock of a domestic corporation is treated as an acquisition of a proportionate amount of such corporation’s assets. As such, the typical inversion transaction in which 100% of the stock of a US corporation is transferred to a foreign corporation is treated as an acquisition of 100% of the US corporation’s assets. In addition, amendments to the regulations clarified that a downstream merger of a US corporation into its foreign subsidiary is an acquisition of assets of a US corporation to which section 7874 should apply. However, the regulations provide that the acquisition of the stock of a foreign corporation with a US subsidiary corporation is not treated as an acquisition of the assets of the US subsidiary. Consequently, acquisitions of foreign target corporations with US subsidiaries generally do not implicate section 7874. The regulations also have anti-abuse rules to prevent taxpayers from avoiding the scope of section 7874 by using multiple foreign acquiring entities.

Ownership test

A starting issue to be examined under the ownership test is whether the former shareholders of the US target corporation received their stock in the foreign acquiring corporation by reason of their ownership of US target corporation stock. Consider the following example: an individual owns 100% of the stock of a US corporation having a value of $300x, as well as additional non-stock business assets having a value of $300x. If the individual contributes both the US corporation stock and the non-stock assets to a newly formed foreign corporation as part of an integrated plan, then only 50% of the stock of such foreign corporation is received by the individual “by reason of” the ownership of the US corporation stock, and section 7874 would not apply because neither the 60% nor 8o% ownership thresholds has been reached.

Certain issuances of the foreign acquiring corporation’s stock are disregarded for purposes of measuring ownership. Section 7874(c)(2)(B) states that stock of a foreign acquiring corporation is disregarded if it is either (i) held by a member of the EAG including the foreign acquiring corporation or (ii) sold in a public offering related to the acquisition of the US corporation. Therefore, certain attempts to dilute the ownership of the former shareholders of the US target are disregarded. It had been thought that only publically issued stock was disregarded so that, for example, privately placed would still be counted. However, any escape hatch was eliminate with the publication of Notice 2009-78, which provided that any stock of the foreign acquiring corporation that is issued in exchange for “nonqualified property” in a transaction related to the acquisition is not taken into account in measuring ownership. Notice 2009-78 defined nonqualified property as: (i) cash or cash equivalents, (ii) marketable securities or (iii) any other property acquired with a principal purpose of avoiding the purposes of section 7874. Even with these limitations, following the 2012 changes to the “substantial business activities” test (discussed below), some feel that efforts to avoid the application of section 7874 will center around on the ownership test.

Substantial business activities test

Section 7874 does not apply to an inversion if the foreign acquiring corporation has “substantial business activities” in the jurisdiction where it is incorporated when compared with the overall activities of its EAG. The test is satisfied if:

1. after the acquisition, the group employees based in the foreign country accounted for at least 25% (by headcount and compensation) of total group employees;
2. after the acquisition, the total value of the group assets located in the foreign country represented at least 25% of the total value of all group assets; and
3. during a 12-month testing period, the group sales made in the foreign country accounted for at least 25% of total group sales.

The regulations limit the types of assets, employees and income that satisfy each requirement. These requirements are considered as being so strict, as to make it very hard for most transactions to meet this test.

Section 4985

An excise tax imposed under section 4985, applies to specified holders of stock-based compensation. The tax is imposed on a “disqualified individual” of an “expatriated corporation,” but only if a gain is recognized, in whole or in part, by any shareholder as a result of the inversion transaction. A “disqualified individual” is generally an insider of the corporation, while an expatriated corporation has the same meaning as in section 7874(a)(2) (that is a domestic target acquired in a 60% inversion). For those persons subject to the provision, an excise tax is imposed (at a rate of 15%) on the value of the specified stock compensation held by or for the benefit of such person, including by a member of such person’s family, during the 12-month period beginning on the date that is six months before the expatriation date. For the most part, such stock compensation is any payment (or right to payment) granted by the expatriated corporation in connection with the performance of services if the value of such payment is based on the value of stock in such corporation.

The opinions expressed herein are solely those of Mr. Kiggins and not those of Culhane Meadows PLLC.

Notes

[1] This was an acquisitive merger in which the former Perrigo shareholders acquired control of Elan for $6.7 Billion in cash and stock.

[2] A fault line is a place where tectonic plates which are moving, albeit at a glacial pace, in different directions meet. The plates are somewhat locked into place but as enough energy builds up it releases as an earthquake which can, depending on the severity, be a very sudden violent and massive displacement of the ground.

[3] This is an informational summary only derived from secondary sources and should not be relied on for making any tax decisions. The laws, rules, and regulations in this area are highly technical and subject to change – even retroactively. Independent tax counsel should be engaged.